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Sunday, November 09, 2003

Yet One More Article from The Economist

Bret, a few weeks ago you challenged my statement about people living beyond their means. This article from this week's Economist is my response. It makes an interesting reference to Hayek and von Mises.

America's economy

Another hangover in the making?

Nov 6th 2003
From The Economist print edition

America's spurt in growth is being fuelled by a dangerous cocktail

EVER since America's stockmarket bubble burst in 2000, The Economist has argued that America faced several years of sluggish growth, if not a deep recession, as the economy worked off the excesses that built up in the late 1990s. Yet the economy has come roaring back, with GDP rising by 7.2% at an annual rate in the third quarter—its fastest sprint for 19 years. Do we look a bit silly? Indeed. But there are still big risks ahead.

Certainly, the recent recovery has been startling. Over the past year, America's GDP grew by 3.3%. Growth is becoming more balanced. In the third quarter, consumer spending rose by 6.6% at an annual rate, but business investment was also up by an impressive 11%, housing investment grew by 20%, and even exports jumped by 9%. Corporate profits are rebounding and figures due on November 6th were widely tipped to show that business productivity grew at an astonishing 8% or thereabouts in the third quarter.

The Federal Reserve

Many pundits have argued that America's brisk rebound, despite all that it has suffered—the bursting of the bubble, September 11th, corporate scandals and the Iraq war—proves just how wonderfully flexible and resilient its economy is. Flexibility played a part, but a smaller one than many believe. The main reason why the economy has held up better than expected is that it has enjoyed the biggest fiscal and monetary stimulus in decades.

No other country has experienced such a huge increase in its structural-budget balance (ie, excluding the automatic effect of the economic cycle). Thanks partly to tax cuts, it has swung from a structural surplus of 1% of GDP in 2000 to a deficit of 5% this year. Meanwhile, historically low interest rates sparked a boom in mortgage refinancing, giving households lots more extra cash to spend. And spend they have.

But the government cannot carry on handing out such largesse for ever. America's deteriorating fiscal finances rule out further big net tax cuts (see article). Long-term interest rates have also risen, and as a result mortgage refinancing has fallen by around 80% from its peak. In September real consumer spending dipped by 0.6%. If job lay-offs continue, consumers may also tighten their belts.

Business investment is picking up, but ample spare capacity will continue to discourage new spending. In September, manufacturing output was running at only 73% of capacity, well below the average of 81% over the past half century. In any case, business investment is too small a share of the economy to keep it aloft in the absence of robust consumer spending.

But the main reason for doubting that America is back on a path of strong, sustainable growth is that it has failed to purge the excesses of its previous boom. It is, to say the least, odd that at the beginning of an economic recovery many indicators—low saving, rampant household borrowing, record house-building and uncomfortably high stockmarket p/e ratios to name but a few—have more the look of a cycle that is drawing to a close.

Debt provides the best example. In the year to the second quarter (the latest figures available), borrowing by households rose by 11%, its fastest pace in real terms since 1985. Economists wearing rose-tinted spectacles point out that interest rates today are low, so households can afford to borrow more. The main snag with this argument (but by no means the only one) is that, despite low interest rates, households' debt-service payments are alarmingly high as a percentage of their income. The Federal Reserve has recently revised its measure of household debt-service. In contrast to the old figures, this now shows that the debt-service ratio is higher than at its previous peak in the 1980s.

When interest rates inevitably rise to normal levels, debt-service ratios will rise higher still. But even while interest rates remain low, debt service will eat up a rising share of income if households keep borrowing more. Sooner or later, consumers will need to save more and spend less.

This week, both the Reserve Bank of Australia and the Bank of England raised interest rates largely because of concerns about soaring household debt. The Fed has instead signalled that it intends to keep interest rates low for some time in order to support the recovery. Given America's greater economic slack and hence the risk of deflation, that is understandable.

Alpine reflections
Why has this situation arisen? Austrians are in vogue in America, at least in California, so perhaps it is a good time to dust down Austrian business-cycle theory. This helps to explain why this economic cycle is different to previous post-war cycles, and why a full recovery could be delayed.

Early last century, economists such as Ludwig von Mises and Friedrich Hayek argued that, if interest rates were held below their “natural rate” (at which the supply of saving from households equals the demand for investment funds by firms), credit and investment will rise too rapidly and consumers will not save enough.

Sound familiar? America displayed many of those features in the late 1990s. Faster productivity growth raised the natural rate of interest, but because inflation was low (and because Austrian economics had long been out of fashion) the Fed failed to lift interest rates by enough. Investment and borrowing boomed.

Strict Austrian-school disciples would argue that, because America's recent downturn was due to overinvestment and overborrowing, slashing interest rates to encourage yet more borrowing was wrong because it delayed the need for households to save more. Central banks can postpone a downturn only by injecting more and more credit. The inevitable downturn is then deeper or longer.

But having made the mistake of allowing a bubble to inflate and then burst, the Fed now faces a difficult balancing act: trying to prevent deflation, while at the same time avoiding a credit bubble which may burst even more painfully.

Joachim Fels, an economist at Morgan Stanley, accuses the Fed of being a serial bubble blower. Slashing interest rates and pumping out liquidity every time a bubble bursts—from the Asian and Russian crises to the stockmarket bubble—creates yet another. America's latest bubble is in house prices and mortgage financing. By rescuing investors from their folly each time, central banks encourage increased risk-taking. On this view, the Fed will eventually run out of soap and the last bubble will burst.

Copyright The Economist November 6, 2003

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